Employee stock option plans (ESOPs) were conceived to be a “win-win” for businesses, under the right circumstances. The premise is, when employees have an equity stake in the company they work for, their interests will be aligned with owners because they actually become owners themselves.
Congress established tax benefits for ESOPS to help business owners overcome possible concerns about the administrative complexity involved in establishing and maintaining an ESOP. Approximately 7,000 companies now sponsor ESOPs. Small employers often use these plans as an exit strategy, and happily sell their company over to the ESOP and, by extension, their employees.
About 13.4 million workers are covered by employee stock option plans, whose combined assets total approximately $940 billion, according to the Employee Benefit Research Institute. For roughly one-third of the companies which sponsor them, ESOPs are the only retirement plan.
ESOPs exist as a trust whose sole purpose is to hold employer stock on behalf of employees. As employees retire, employee shares are purchased back from them by the ESOP. The company makes tax-deductible cash contributions to the ESOP, enabling the trust to purchase company stock from owners.
In other words, owners are financing their own buy-out from company profits with pre-tax dollars. In addition, ESOPs can borrow funds to purchase employer stock, but the company will still need to make cash contributions to the trust sufficient for the ESOP to service the debt it incurred.
For business owners, the proceeds from the sale of their stock to the ESOP are generally fully taxable (depending on their tax basis) — unless the proceeds are reinvested into publicly traded stock or bonds. In that case, taxes are deferred until those investments are sold. The calculations can be complex, requiring the assistance of a tax professional.
Problems arise when owners use overly optimistic valuations to set the price of company stock they sell to the ESOP. Since the beginning of the Obama administration, the Department of Labor (DOL) has aggressively sought out cases it considers to include abusive valuations. The DOL has pursued 28 cases and recovered $241 million through out-of-court settlements. Trust companies serving in a custodial capacity for ESOPs have also been in the cross-hairs when they fail to monitor stock valuations.
DOL on the Prowl
In early June, for example, the DOL reached a $5.25 million settlement with GreatBanc, which served as trustee for an ESOP of Sierra Aluminum Co., a metal products company in Riverside, California. The ESOP had 385 participants. The DOL asserted that GreatBanc had failed to review the methodology employed by a valuation firm, resulting in what the DOL maintains were “unrealistic and aggressively optimistic assumptions” of the company’s earnings. The DOL also charged GreatBanc with asking the valuation company to adjust its valuation upward to match the target share price.
In another case earlier this year, the DOL reached a $10 million settlement with two owners of a New York-based care-giving service called People Care. The owners and the company itself were charged with “failing to correct unrealistically optimistic projections of [the company’s] future earnings.” The projection (and thus the company’s valuation) failed to reflect the impact of the recent loss of a large customer.
Also, the DOL argued that the stock purchase agreement was invalid because it contained a provision indemnifying the owners against the cost of any litigation or investigations, such as this case. The result was the DOL was required to cover such expenses instead.
In yet another stock over-valuation case (Chesemore et al v. Alliance Holdings Inc.) the owners didn’t settle, and the U.S. District Court for the Western District of Wisconsin resolved the dispute. A key factor in this case was that the company’s valuation failed to take into account the financial impact of the debt the ESOP (that is, the new owner of the company) incurred to buy out its owners. The impact of the debt was to cut the value of the stock by about 75 percent.
Supreme Court Verdict
Finally, the U.S. Supreme Court issued a unanimous ruling on June 25 in Bancorp et al v. Dudenhoeffer et al in which it shot down a prevailing legal standard called the “Moench Presumption.” That doctrine in effect gave ESOP fiduciaries the benefit of the doubt in litigation arising from a drop in the value of the employer stock.
Lower courts sympathized with ESOP trustees who were trapped between two requirements: To carry out the ESOP’s basic purpose through purchasing and holding employer stock, and looking out for the best interests of ESOP plan participants.
“ESOP fiduciaries are not entitled to any special presumption of prudence. Rather, they are subject to the same duty of prudence that applies to ERISA fiduciaries in general,” the court held. The ruling is most pertinent to publicly held companies, however, whose ESOP fiduciaries can view market-based stock valuation any time securities markets are open.
The bottom line for small employers: ESOPs can still be a successful employee compensation, motivation and owner transition strategy all rolled into one. But ESOPs are not an easy means to get an above-market price for your company.